The Economics of a Temporary VAT Cut*

This paper analyses the likely implications of the temporary cut in VAT in the UK to 15 per cent, with a return to 17.5 per cent in place for the end of 2009. We distinguish between the income effect of the cut and the (intertemporal) substitution effect. The former is likely to be small because the change in lifetime income is minimal. The second effect is likely to be much more important because the reduction in the price of goods bought in 2009 compared with 2010 gives an incentive to increase consumer spending this year. With an elasticity of intertemporal substitution of about 1, we would expect the cut in VAT to boost consumer spending by about 1.2 per cent over what it would otherwise be. The distributional consequences of the VAT cut are regressive because goods subject to VAT tend to be luxuries. Unlike a cut in interest rates, there is no difference in the distributional consequences for borrowers compared with savers.